Proposed Changes in Risk- Based Capital Rules for U.S. Life Insurance Investments: A Game Changer for CIOs?

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1 QUANTITATIVE RESEARCH December 216 Proposed Changes in Risk- Based Capital Rules for U.S. Life Insurance Investments: A Game Changer for CIOs? AUTHORS Soraya Kazziha Executive Vice President Head of EMEA Client Analytics Chitrang Purani Senior Vice President Portfolio Manager We analyze the impact of proposed changes in the National Association of Insurance Commissioners capital charges on the fixed income investment portfolios of U.S.-domiciled life insurers. Starting from an estimated current fixed income allocation for the sector, we discuss possible shifts in the optimal allocation that would result from the proposed changes in risk weights, and their possible market implications. The main features of the proposed changes are, first, to reduce the capital cost of high yield and AAA-rated paper while increasing the costs for the rest of the investment grade universe. Given the industry s dominant exposure to investment grade and modest exposure to high yield, the net effect of the proposed changes would be to increase the overall capital charge of fixed income portfolios. 1 Second, the gap between the capital charges of BBB- and BB+ ratings would markedly narrow, by more than half. This has led a number of market participants to conclude perhaps too hastily, in our view that these changes would encourage insurers to increase their allocation to high yield. Our analysis suggests a more nuanced outcome and, if anything, a potential reallocation into higher-rated buckets, away from high yield and toward higher-quality secured debt and/or less liquid sources of yield. Over time, the flattening of the capital cost curve across BBBs through BBs may help soften forced sales of securities downgraded to high yield, but the relative capital efficiency will still be low. We also believe any potential shifts will be more of an influence on reinvestment flow than on the stock of life investments, given solid initial capital levels and accounting and sourcing frictions related to investment turnover. Additionally, long-term reinvestment decisions are likely to be driven more by broad operational and market shifts for the industry (i.e., premium growth, interest rates and valuations), which will continue to have larger influences on asset allocation.

2 2 December 216 Quantitative Research 1. INTRODUCTION AND CONTEXT Under the new proposal, the granularity of the risk categories has increased from six to 2 buckets. For example, under current rules, all investment grade securities rated between AAA and A- fall within category 1, attracting the same risk weight of.3%, while under the new proposal each rating would define a separate category attracting a different level of risk charge (see Table 1), with lower-rated bonds assigned higher risk weights. The current rule favors allocations to A- over AAA, BBB- over BBB+, and so forth, an effect the new rules are trying to correct to align more closely with historical loss experience in these specific ratings categories. Furthermore, the risk weights across the investment grade universe would notably increase, by an average of.3%. Single A ratings are most penalized, with an increase of.%, while the risk weights of the high yield universe would, on average, decrease by 1% and BB+ and B+ weights would decrease by.8% and 3.1%, respectively. Using Barclays and J.P. Morgan indexes as benchmarks for the various rating buckets of the investment universe, taking into account the industry s average allocation to various sectors of credit within each ratings category, we define the default-adjusted spread per unit of C1 charge as a measure of the capital efficiency of each risk category (loosely referred to here as return on capital, or RoC). Please refer to the appendix for a detailed description of the benchmark definitions. Using market levels as of 29 July 216, the gap between the RoC of the BBB- bucket and the BB+ bucket has narrowed quite significantly under the proposed rule (see Figure 2), while the capital efficiency of the single-a versus the BBB buckets has notably deteriorated. Given the relatively modest exposure to high yield approximately 6%, on average, for the life insurance sector we would expect a sizable increase in the minimum capital requirement under the new proposal. Table 1: Current and proposed risk weights Current factors (after-tax) Proposed factors (after-tax) Change U.S. Govt.%.%.% AAA.3%.2% -.1% AA+.3%.3%.% AA.3%.%.2% AA-.3%.6%.3% A+.3%.7%.4% A.3%.8%.% A-.3%.9%.6% BBB+ 1.% 1.1%.1% BBB 1.% 1.2%.3% BBB- 1.% 1.%.% BB+ 3.4% 2.6% -.8% BB 3.4% 3.2% -.2% BB- 3.4% 4.1%.7% B+ 7.4% 4.3% -3.1% B 7.4%.7% -1.7% B- 7.4% 7.4%.% CCC+ 17.% 1.4% -6.6% CCC 17.% 14.3% -2.7% CCC- 17.% 21.% 4.% Lower and non-rated 19.% 19.%.% Source: American Academy of Actuaries C1 Work Group as of 3 August 21

3 December 216 Quantitative Research 3 Can these changes and, in particular, the relative increase in the capital efficiency of high yield and the marked deterioration of the capital efficiency of A buckets potentially lead U.S. life insurers to shift their allocation out of A into AAA/AA and BB, thereby increasing their allocation to high yield and a generally more barbelled shift to portfolios? Figure 1: Change in risk-based capital AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- -7% -6% -% -4% -3% -2% -1% % 1% 2% 3% 4% % Source: PIMCO as of July 216 Figure 2: RoC by rating Current AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- Proposed Source: Barclays, J.P. Morgan, Moody s and PIMCO as of July TYPICAL ALLOCATION We estimated the average general accounts fixed income allocation for the life insurance sector and, as discussed previously, mapped it to public benchmarks. We found that as of the end of July 216, the typical allocation had a default-adjusted spread of 19 basis points, a nominal duration of approximately 11 years and a C1 charge (loosely referred to as RBC in the rest of this document) of 1.2% under the current rules and 1.4% under the proposed rules. Please refer to Figure 3 and Table 2 below. Figure 3: asset allocation for U.S. life insurance sector 33.2% 6.% 2.% 6.1% 28.9% Source: SNL as of 31 December % 11.3% Treasuries AAA BBB Table 2: asset allocation statistics BB and B AA A allocation OAS 1.9% RBC (current) 1.2% RBC (proposed) 1.4% Duration 11.1 RoC PORTFOLIO OPTIMIZATION SETUP Lower We suggest reformulating the question of the potential impact of the change in capital rules in terms of a constrained portfolio optimization problem using capital-adjusted spread metrics. However, we recognize that in order for such an optimization to have any predictive efficacy, it needs to capture the other, often complex, structural factors that insurers face in their general account investment decisions, such as accounting, diversification requirements, asset/liability management, limited use of leverage and/or derivatives, etc.

4 4 December 216 Quantitative Research We propose to (partially) address these issues in three steps. First, we start from the estimated average fixed income allocation for the sector described in the previous section ( typical allocation ), which we would argue should generally reflect the constraints U.S. insurers face. Second, we constrain the optimizations to only allow for limited shifts (±2%) in allocation within each (sub)rating bucket i.e., AAA, AA+, AA, AA-, etc. as well as a limited shift in the overall nominal duration of the optimal portfolio (±1 Yr), to ensure consistency with broader ALM objectives. Finally, we disallow any leverage in the optimal portfolio (all weights are positive and add up to 1%). Additionally, we keep allocations to CCC ratings and below unchanged, as it is reasonable to assume that insurers are unlikely to allocate new flows to these legacy positions or sell them for accounting reasons. We have considered two different objective functions for the constrained optimizations. In the first one, we solve for the portfolio allocation that maximizes RoC (subject to the previously discussed weights and duration constraints) that is, we solve for the most capital efficient allocation, independent of the level of capital at disposal. As RBC capital can be viewed as a regulatory measure of risk, this is equivalent to solving for the allocation that maximizes the regulatory Sharpe ratio of the portfolio. In the second case, we solve for the portfolio allocation that maximizes the default-adjusted spread of the portfolio, subject to a maximum allowable RBC (and also to the same weights and duration constraints). This is analogous to targeting the highest yield for a given level of RBC in the context of our stable duration constraint. 4. OPTIMIZATION RESULTS First, we focus on the RoC-maximizing portfolios, in the columns under the header Max RoC in Tables 3a and 3b. We observe that the optimal portfolios do not emphasize high yield under either set of rules. Although the capital efficiency of high yield has improved under the proposed rules, it nevertheless remains the least efficient asset class. We note, however, that the optimal allocation to the single-a risk buckets would drop under the proposed rules, to the benefit of the BBB bucket. This is in line with what we find in Figure 2. Under the current rules, A-rated securities have the highest RoC, and therefore it is optimal to allocate as much as allowable within the constraints of the optimizations. However, under the proposed rules, A-rated securities have an RoC similar to that of BBBs. We turn now to the spread- (or yield-) maximizing portfolios under the headers Max OAS/RBC = 1.2% and Max OAS/RBC = 1.4%. Comparing Table 3a with Table 3b, in each category we find that for the same level of capital consumption, high yield is less capital efficient at the portfolio level under the proposed rules than it is under the existing rules. For example, it moves from 6.8% to % when RBC is capped at 1.2% and from 11.4% to.9% when RBC is capped at 1.4%. In other words, when capital is limited, the dominating effect of the proposed rules is the overall increase of required capital, which forces an overall migration into higher-rated securities (and in particular a reduction of exposure to high yield) and the loss of yield. We now consider the case in which the insurer is willing and/or able to stomach the higher RBC cost (1.4%) of the current allocation. We find that the optimal allocation to high yield would be broadly unchanged (6% versus.9%). This apparent status quo is, in fact, the result of two compensating effects. Indeed, for a higher capital budget, the current allocation is suboptimal and could be increased from 6% to 11.4%. However, the forced migration into higher-rated buckets induced by the proposed rules reduces the allocation to high yield to virtually the same level as the starting point. To highlight this allocation trade-off of ratings and capital consumption, in Figure 4 we show the optimal allocation in AA and high yield buckets, which maximizes the yield (defaultadjusted option-adjusted spread (OAS)) of the portfolio for increasing levels of C1 capital budgets for the two different regimes. Indeed, we find that for the same-level C1 budget (and a maximum allowable allocation shift of ±2%), the optimal allocation to AA is systematically higher (or equal at higher levels of capital budget) under the proposed rules than under existing rules. Conversely, the optimal allocation to high yield is systematically lower under the proposed rules than it is under existing rules.

5 December 216 Quantitative Research Table 3a: Allocations and statistics of optimal portfolio under the current rules Asset class Max OAS Max OAS Max RoC RBC = 1.2% RBC = 1.4% RBC = 1.4% Treasuries 6.1% 4.1% 4.1% 4.1% AAA 12.1% 1.1% 1.1% 1.1% AA 11.3%.3%.3% 17.3% A 28.9% 32.1% 27.% 34.9% BBB 33.2% 39.2% 39.2% 31.2% BB and B 6.% 6.8% 11.4%.% Lower 2.% 2.% 2.% 2.% OAS 1.9% 2.% 2.1% 1.8% RBC 1.2% 1.2% 1.4%.9% Duration RoC Table 3b: Allocations and statistics of optimal portfolio under the proposed rules Asset class Max OAS Max OAS Max RoC RBC = 1.2% RBC = 1.4% RBC = 1.4% Treasuries 6.1% 4.1% 4.1% 4.1% AAA 12.1% 13.% 1.1% 1.1% AA 11.3% 17.3% 7.4% 17.3% A 28.9% 26.9% 3.9% 26.9% BBB 33.2% 3.7% 39.2% 39.2% BB and B 6.%.%.9%.% Lower 2.% 2.% 2.% 2.% OAS 1.9% 1.8% 2.% 1.9% RBC 1.2% 1.2% 1.4% 1.2% Duration RoC

6 6 December 216 Quantitative Research Figure 4: Optimized allocation under the current and proposed rules versus the typical life insurer allocation Allocation 2% 1 1 AA RBC (%) Proposed Current Allocation 22% HY RBC (%) Proposed Hypothetical example for illustrative purposes only. Refer to appendix for additional hypothetical example, OAS and return assumptions information SENSITIVITY ANALYSIS Current In the previous section we constrained the maximum reallocation in each rating bucket to be ±2%. We tested the robustness of our results for shift sizes ranging from ±.1% to ±%, constraining a capital consumption of 1.4% under the proposed rules. We found that for modest (low single digit) levels of turnover at the portfolio level, the optimal level of high yield was overall unchanged compared with the typical insurer s current allocation. Separately, we looked into the sensitivity of our analysis to the spread environment and found that results were consistent across different historical spread regimes. Indeed, the results were primarily driven by the relative RoC, and in order for high yield to be efficient under the proposed rules and capital consumption limited to 1.2% (see Table 3b under header Max OAS/RBC = 1.2% ), we would need the ratio of BB spreads to BBB spreads to be of the order of 3, which are levels not seen even at the peak of the 28 crisis (see appendix for detailed results) OPTIMIZATION RESULTS IN PRACTICE, AND THEIR MARKET IMPACT The desire to maintain high legacy accounting yields, the need for diversification and strong global demand for high quality credit spread make it unlikely that life insurers will meaningfully turn over existing holdings to migrate toward desired ratings allocation targets. It s more likely that any transition will occur via reinvestment flow versus rebalancing the existing stock of assets. However, for market participants, even changes in flow should be closely monitored, as the life insurance industry reinvests more than $ billion of cash flow annually. All else equal, optimization results imply marginally weaker demand for A-rated securities in favor of more barbelled reinvestment within the investment grade universe, into AAand higher-rated buckets (supportive for high quality securitizations, municipals/sovereigns and select corporate issues) as well as BBB corporates. High yield securities should actually exhibit a neutral-to-negative reinvestment growth trend if insurers aim to normalize C1 capital back to its levels before the proposed changes. Additionally, liquidity premia should become an even more desirable source of income as the capital costs for investment grade capital rise under the proposed rules. However, it s worth noting that all potential reinvestment shifts will vary based on operational, market and other constraints. For example, since 27, BBBs have represented a larger (and growing) proportion of fixed income reinvestment across insurers despite having approximately half the capital efficiency of As under the current RBC framework. This has been driven by ratings migration and declining reinvestment yields increasingly pushing reinvestment into the lower end of the investment grade spectrum in order to mitigate margin decline (Figure ). If insurers rigidly reinvested based on capital-adjusted return alone, BBB exposures would likely be much lower. Another by-product of the proposed changes is the flattening of the capital cost curve across the investment grade/high yield border. Specifically, the potential change in capital charge between BBB- and BB+ drops from 2.4% to 1.1% - i.e., by more than half. This shift is also meaningful for markets, given the countercyclical trading activity that often occurs around high yield downgrades, or fallen angels, across insurers. For example, Figure 6 shows monthly and cumulative net transactions across a broad group of larger fallen angels just before and after their respective high yield ratings events. The data show how sales spike in the months preceding and immediately after the high yield downgrades. Although downgrade-driven sales may still naturally occur due to fundamental concerns, a subset of selling activity triggered by the desire to avoid the BBB to BB capital-charge jump may be meaningfully reduced.

7 December 216 Quantitative Research 7 Figure : Cumulative % change in fixed income holdings by ratings bucket 8.% Y 26Y 27Y 28Y 29Y 21Y 211Y 212Y 213Y 214Y 21Y >= A BBB < IG Long corp YTW (rhs) Source: SNL, Barclays and PIMCO as of 31 December 21 8% CONCLUSIONS We have shown that the stand-alone improvement in capital efficiency of high yield relative to higher-rated investments under proposed RBC rules would not necessarily translate into higher optimal allocations at a total fixed income portfolio level. In fact, given the existing level of exposure to the middle of the investment grade ratings spectrum, the dominating effect would be to increase the overall capital cost, which, all else equal, would lead the less well capitalized insurers to reduce their exposure to high yield and, most likely, those at the higher end of the RBC ratio spectrum to maintain their current allocation to high yield. Over time, however, the flattening of the capital cost curve between BBBs and BBs may alleviate countercyclical selling upon the downgrades of current investment grade issuers to high yield. Figure 6: Monthly and cumulative net sells ($mm) of fallen angels, 2 T-6 through T+6 months from high yield rating event , -1, -2, -2, -3, -3, There also exists an incentive to barbell reinvestment within the investment grade spectrum into AAAs/AAs and BBBs, but we would continue to expect that the overall level of interest rates and valuations, operational cash flows and fixed income supply dynamics will play a larger role in determining allocation changes and market impact at the detailed ratings level. Net trans Cumulative net trans (rhs) Source: SNL and PIMCO 21 Endnotes 1 Actual changes in aggregate capital at the entity level may be influenced by covariance adjustment, changes in asset valuation reserves, shifts in other non-fixed-income RBC charges and/or other impacted measures fallen angels used from 213 through 21: ADT, MTNA, CTL, HNZ, FE, NOKIA, TITIM, SLMA, RIG, CLF, PETBRA, GAZPRU, PRCGEN, ALBLLC, DPM, DCPMID and GNW References American Academy of Actuaries C1 Work Group, Model Construction and Development of RBC Factors for Fixed Income Securities for the NAIC s Life Risk-Based Capital Formula, 3 August 21 Moody s Default and Recovery , probabilities of default estimated between 1983 and 21 Barclays POINT data, as of 29 July 216: Barclays US Treasuries, Barclays US Credit, Barclays US High Yield, Barclays US MBS, Barclays US ABS and Barclays US CMBS

8 8 December 216 Quantitative Research A. APPENDIX A.1. Optimization parameters Table 4 summarizes the various optimization parameters. The default-adjusted OAS have been computed using Barclays and J.P. Morgan indexes as well as Moody s default probabilities and an assumption of 4% recovery rate (see Table ). Table 4: Optimization parameters Asset class Rating allocation OAS Duration RBC Constraints vs. swaps Def-adj OAS Total Current Proposed Min Max AAA 6.1%.4%.4% 13..%.% 4.1% 8.1% AAA 12.1%.6%.6% 3.8.3%.2% 1.1% 14.1% AA+ 3.6% 1.23% 1.23% %.31% 1.6%.6% Credit investment grade AA 2.7% 1.28% 1.28% %.4%.7% 4.7% AA-.% 1.41% 1.39% %.7% 3.% 7.% A+ 6.8% 1.8% 1.3% 13..3%.69% 4.8% 8.8% A 1.7% 1.8% 1.% %.81% 8.7% 12.7% A- 11.4% 1.77% 1.74% 13..3%.94% 9.4% 13.4% BBB+ 13.4% 2.31% 2.22% % 1.7% 11.4% 1.4% BBB 11.1% 2.4% 2.34% % 1.21% 9.1% 13.1% BBB- 8.7% 3.22% 3.6% % 1.4% 6.7% 1.7% BB+ 1.8% 3.1% 2.83% % 2.6%.% 3.8% BB 1.4% 3.3% 3.9% % 3.16%.% 3.4% BB- 1.% 3.83% 2.97% % 4.%.% 3.% Credit high yield B+.8% 4.29% 3.4% % 4.31%.% 2.8% B.%.2% 3.69% %.66%.% 2.% B-.%.71% 2.64% % 7.42%.% 2.% CCC+.2% 8.16%.27% % 1.4%.2%.2% CCC.4% 11.82%.34% % 14.29%.4%.4% CCC-.3% 17.63% 6.16% % 21.47%.3%.3% Lower 1.% 23.71% 9.1% % 19.% 1.% 1.% Portfolio 1% 2.28% 1.89% % 1.4% 16% Turnover

9 December 216 Quantitative Research 9 Table a: Asset class construction Asset class Benchmarks Average exposure OAS Default-adjusted OAS Credit Structured products (S.P.) Total Credit S.P. Total Credit S.P. Total Credit S.P. TSY Barclays US Long Treasury Barclays US MBS GNMA 6.11% 4.1% 1.96%.4%.%.13%.4%.%.13% AAA Barclays US Long Credit Mix* 12.1% 1.34% 1.76%.6% 1.6%.4%.6% 1.6%.4% AA+ Barclays US Long Credit Barclays US ABS 3.6% 2.78%.78% 1.23% 1.26% 1.13% 1.23% 1.26% 1.13% AA Barclays US Long Credit Barclays US ABS 2.71% 2.27%.44% 1.28% 1.31% 1.14% 1.28% 1.31% 1.14% AA- Barclays US Long Credit Barclays US ABS 4.99% 4.32%.67% 1.41% 1.43% 1.31% 1.39% 1.4% 1.28% A+ Barclays US Long Credit Barclays US ABS 6.76% 6.1%.61% 1.8% 1.61% 1.2% 1.3% 1.6% 1.2% A Barclays US Long Credit Barclays US ABS 1.74% 9.87%.88% 1.8% 1.9% 1.4% 1.% 1.6% 1.37% A- Barclays US Long Credit Barclays US ABS 11.36% 1.47%.9% 1.77% 1.8% 1.42% 1.74% 1.77% 1.38% BBB+ Barclays US Long Credit Barclays US ABS 13.37% 12.4%.83% 2.31% 2.34% 1.7% 2.22% 2.26% 1.67% BBB Barclays US Long Credit Barclays US ABS 11.1% 1.33%.77% 2.4% 2.49% 1.94% 2.34% 2.38% 1.83% BBB- Barclays US Long Credit Barclays US ABS 8.68% 8.4%.64% 3.22% 3.31% 2.12% 3.6% 3.1% 1.9% BB+ Barclays US High Yield Barclays US High Yield 1.8% 1.6%.19% 3.1% 3.1% 3.1% 2.83% 2.83% 2.83% BB Barclays US High Yield Barclays US High Yield 1.44% 1.22%.22% 3.3% 3.3% 3.3% 3.9% 3.9% 3.9% BB- Barclays US High Yield Barclays US High Yield 1.2%.8%.16% 3.83% 3.83% 3.83% 2.97% 2.97% 2.97% B+ Barclays US High Yield Barclays US High Yield.79%.63%.16% 4.29% 4.29% 4.29% 3.4% 3.4% 3.4% B Barclays US High Yield Barclays US High Yield.49%.34%.1%.2%.2%.2% 3.69% 3.69% 3.69% B- Barclays US High Yield Barclays US High Yield.46%.28%.18%.71%.71%.71% 2.64% 2.64% 2.64% CCC+ Barclays US High Yield Barclays US High Yield.23%.7%.16% 8.16% 8.16% 8.16%.27%.27%.27% CCC Barclays US High Yield Barclays US High Yield.39%.%.3% 11.82% 11.82% 11.82%.34%.34%.34% CCC- Barclays US High Yield Barclays US High Yield.32%.1%.3% 17.63% 17.63% 17.63% 6.16% 6.16% 6.16% Lower Barclays US High Yield Barclays US High Yield 1.2%.3% 1.49% 23.71% 23.71% 23.71% 9.1% 9.1% 9.1% Table b: Details of the AAA structured products *Mix Weights OAS Barclays US MBS FHLMC and FNMA.8%.28% Barclays US CMBS AAA 19.8%.7% J.P. Morgan CLO AAA 8.8% 1.4% Barclays US ABS AAA 2.6%.7% Total 1.%.4% Refer to appendix for additional credit quality and OAS information.

10 1 December 216 Quantitative Research A.2. Detailed results Table 6: Detailed allocation to rating buckets Asset class Rating allocation RBC = 1.2% RBC = 1.4% MAX RoC Current Proposed Current Proposed Current Proposed Treasuries AAA 6.1% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% AAA 12.1% 12.1% 1.1% 13.% 1.1% 1.1% 1.1% AA+ 3.6% 1.6%.6% 1.6% 3.7%.6%.6% Credit investment grade AA 2.7%.7% 4.7%.7%.7% 4.7% 4.7% AA-.% 3.% 7.% 3.% 3.% 7.% 7.% A+ 6.8% 6.% 8.8% 4.8% 8.8% 8.8% 8.8% A 1.7% 12.7% 8.7% 9.3% 8.7% 12.7% 8.8% A- 11.4% 13.4% 9.4% 13.4% 13.4% 13.4% 9.4% BBB+ 13.4% 1.4% 1.4% 1.4% 1.4% 11.4% 1.4% BBB 11.1% 13.1% 9.7% 13.1% 13.1% 9.2% 13.1% BBB- 8.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% BB+ 1.8%.4%.% 3.8% 3.8%.%.% BB 1.4% 3.4%.% 3.4% 2.%.%.% BB- 1.% 3.%.% 3.%.%.%.% Credit high yield B+.8%.%.%.%.%.%.% B.%.%.% 1.1%.%.%.% B-.%.%.%.%.%.%.% CCC+.2%.2%.2%.2%.2%.2%.2% CCC.4%.4%.4%.4%.4%.4%.4% CCC-.3%.3%.3%.3%.3%.3%.3% Lower 1.% 1.% 1.% 1.% 1.% 1.% 1.% OAS 1.9% 2.% 1.8% 2.1% 2.% 1.8% 1.9% RBC 1.2% 1.2% 1.2% 1.4% 1.4%.9% 1.2% Duration RoC KRD. Yr KRD 2 Yr KRD Yr KRD 1 Yr KRD 2 Yr KRD 3 Yr

11 December 216 Quantitative Research 11 A.3. Robustness of results to a larger reallocation of band of +/- % Table 7: Detailed allocation to rating buckets Asset class Rating Allocation RBC = 1.2% RBC = 1.4% MAX RoC Current Proposed Current Proposed Current Proposed Treasuries AAA 6.1% 1.1% 1.1% 1.1% 1.1% 1.1% 1.1% AAA 12.1% 7.1% 11.% 7.1% 7.1% 7.3% 7.1% AA+ 3.6%.% 8.6%.%.%.% 8.6% Credit investment grade AA 2.7%.% 7.7%.%.% 7.1% 7.7% AA-.%.% 1.%.%.% 1.% 1.% A+ 6.8% 4.% 11.8% 1.8% 11.8% 11.8% 11.8% A 1.7% 1.7%.7% 12.3%.7% 1.7%.7% A- 11.4% 16.4% 6.4% 16.4% 16.4% 16.4% 6.4% BBB+ 13.4% 18.4% 1.% 18.4% 18.4% 8.4% 18.4% BBB 11.1% 16.1% 6.1% 16.1% 16.1% 6.1% 7.2% BBB- 8.7% 13.7% 13.7% 13.7% 13.7% 13.7% 13.7% BB+ 1.8%.%.%.% 1.9%.%.% BB 1.4% 4.6%.% 6.4%.%.%.% BB- 1.%.%.% 4.3%.%.%.% Credit high yield B+.8%.%.%.%.%.%.% B.%.%.%.%.%.%.% B-.%.%.%.%.%.%.% CCC+.2%.2%.2%.2%.2%.2%.2% CCC.4%.4%.4%.4%.4%.4%.4% CCC-.3%.3%.3%.3%.3%.3%.3% Lower 1.% 1.% 1.% 1.% 1.% 1.% 1.% OAS 1.9% 2.2% 1.9% 2.3% 2.1% 1.9% 2.% RBC 1.2% 1.2% 1.2% 1.4% 1.4%.9% 1.2% Duration RoC

12 12 December 216 Quantitative Research A.4. Robustness of results under the assumption that the insurer has perfect high yield selection skills (i.e., zero realized defaults) Table 8: Detailed allocation to rating buckets Asset class Rating OAS Allocation RBC = 1.2% RBC = 1.4% MAX RoC Min RBC Current Proposed Current Proposed Current Current Current Proposed Treasuries AAA.% 6.1% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% AAA.6% 12.1% 1.1% 13.% 1.1% 1.1% 1.1% 1.1% 1.1% 1.1% AA+ 1.2% 3.6% 1.6%.6% 1.6%.6%.6%.6% 1.6%.6% Credit investment grade AA 1.3% 2.7%.7% 4.7%.7%.7% 4.7% 4.7%.7%.7% AA- 1.4%.% 3.% 7.% 3.% 3.% 7.% 7.% 6.2%.1% A+ 1.% 6.8% 6.2% 8.8% 4.8% 6.6% 8.8% 8.8% 8.8% 8.8% A 1.% 1.7% 12.7% 8.7% 11.% 8.7% 12.7% 8.8% 12.7% 8.7% A- 1.7% 11.4% 13.4% 9.4% 13.4% 13.4% 13.4% 9.4% 13.4% 13.4% BBB+ 2.2% 13.4% 1.4% 1.4% 1.4% 1.4% 11.4% 1.4% 1.4% 1.4% BBB 2.3% 11.1% 13.1% 9.7% 13.1% 13.1% 9.2% 13.1% 13.1% 13.1% BBB- 3.1% 8.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% BB+ 3.1% 1.8%.%.%.% 3.8%.%.%.% 1.9% BB 3.% 1.4% 3.4%.% 3.4% 2.3%.%.%.%.% BB- 3.8% 1.% 3.%.% 3.%.%.%.%.8%.% Credit high yield B+ 4.3%.8%.%.%.%.%.%.%.%.% B.%.%.%.%.4%.%.%.%.%.% B-.7%.%.2%.% 2.%.%.%.%.%.% CCC+.3%.2%.2%.2%.2%.2%.2%.2%.2%.2% CCC.3%.4%.4%.4%.4%.4%.4%.4%.4%.4% CCC- 6.2%.3%.3%.3%.3%.3%.3%.3%.3%.3% Lower 9.2% 1.% 1.% 1.% 1.% 1.% 1.% 1.% 1.% 1.% OAS 1.9% 2.1% 1.8% 2.2% 2.% 1.8% 1.9% 1.9% 1.9% RBC 1.2% 1.2% 1.2% 1.4% 1.4%.9% 1.2% 1.% 1.3% Duration RoC Figure 7: RoC by rating* AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- Current Proposed * RoC represents the fixed income spread return (in percent) divided by the capital charge (in percent). Hypothetical example for illustrative purposes only. Refer to appendix for additional credit quality, hypothetical example, OAS and return asumptions information. Source: Barclays, JP Morgan, Moody s and PIMCO as of 29 July 216

13 December 216 Quantitative Research 13 Figure 8: BB and B allocation as a function of turnover under the proposed rules and with RBC = 1.4% Figure 9: A-rated allocation as a function of turnover under the proposed rules and with RBC = 1.4% BB and B allocation 7% Optimal Starting Turnover (%) Hypothetical example for illustrative purposes only. Refer to appendix for additional credit quality, hypothetical example, OAS and return asumptions information. A-rated allocation 4% Optimal Starting Turnover (%) Hypothetical example for illustrative purposes only. Refer to appendix for additional credit quality, hypothetical example, OAS and return assumptions information.

14 14 December 216 Quantitative Research A.. Robustness of results under the assumption that spreads move back to historical averages We note that while the level of spreads changes with the market environment, the relative attractiveness between investment grade and high yield does not. Table 9: Detailed allocation to rating buckets with spreads at the full sample average (29 September 26 to 31 August 216) Asset class Rating OAS allocation RBC = 1.2% RBC = 1.4% MAX RoC Current Proposed Current Proposed Current Current Treasuries AAA.1% 6.1% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% AAA 1.1% 12.1% 1.1% 12.9% 1.1% 1.1% 1.1% 14.1% AA+ 1.6% 3.6% 1.6%.6% 1.6%.6%.6%.6% Credit investment grade AA 1.7% 2.7%.7% 4.7%.7% 2.4% 4.7% 4.7% AA- 1.7%.% 3.% 7.% 3.% 3.% 7.% 7.% A+ 1.8% 6.8% 6.% 8.8% 4.8% 4.8% 8.8% 8.8% A 1.9% 1.7% 12.7% 8.7% 9.3% 8.7% 12.7% 8.7% A- 2.2% 11.4% 13.4% 13.4% 13.4% 13.4% 13.4% 13.4% BBB+ 2.3% 13.4% 1.4% 12.7% 1.4% 1.4% 11.4% 1.4% BBB 2.4% 11.1% 13.1% 9.1% 13.1% 13.1% 9.1% 9.1% BBB- 3.% 8.7% 1.7% 1.7% 1.7% 1.7% 1.7% 6.7% BB+ 3.8% 1.8% 3.4%.% 3.8% 3.8%.%.% BB 3.9% 1.4% 3.4%.% 3.4% 2.%.%.% BB- 3.6% 1.%.%.% 3.%.%.%.% Credit high yield B+ 3.8%.8%.%.%.%.%.%.% B 4.%.%.%.% 1.1%.%.%.% B- 3.%.%.%.%.%.%.%.% CCC+.1%.2%.2%.2%.2%.2%.2%.2% CCC 4.%.4%.4%.4%.4%.4%.4%.4% CCC- 4.4%.3%.3%.3%.3%.3%.3%.3% Lower.% 1.% 1.% 1.% 1.% 1.% 1.% 1.% OAS 2.1% 2.2% 2.% 2.3% 2.2% 2.% 2.% RBC 1.2% 1.2% 1.2% 1.4% 1.4%.9% 1.2% Duration RoC Source: Barclays, J.P. Morgan, Moody s and PIMCO Figure 1: RoC by rating* AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- Current Proposed *RoC represents the fixed income spread return (in percent) divided by the capital charge (in percent). Hypothetical example for illustrative purposes only. Refer to appendix for additional credit quality, hypothetical example, OAS and return assumptions information. Source: Barclays, J.P. Morgan, Moody s and PIMCO as of 29 September 26 to 31 August 216

15 December 216 Quantitative Research 1 Table 1: Detailed allocation to rating buckets with spreads at the pre-crisis average (29 September 26 to 31 December 27) Asset class Rating OAS allocation RBC = 1.2% RBC = 1.4% MAX RoC Current Proposed Current Proposed Current Current Treasuries AAA.2% 6.1% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% AAA.8% 12.1% 1.1% 14.1% 1.1% 1.1% 1.1% 14.1% AA+ 1.1% 3.6% 1.6%.6% 1.6% 1.6%.6%.6% Credit investment grade AA 1.% 2.7%.7% 4.7%.7%.7% 4.7% 4.7% AA- 1.%.% 3.% 3.% 3.% 3.% 7.% 7.% A+ 1.2% 6.8% 6.% 8.8% 4.8% 7.4% 8.8% 8.8% A 1.3% 1.7% 12.7% 12.7% 9.3% 12.7% 12.7% 12.7% A- 1.3% 11.4% 13.4% 9.4% 13.4% 13.4% 13.4% 9.4% BBB+ 1.% 13.4% 1.4% 1.4% 1.4% 1.4% 11.4% 1.4% BBB 1.% 11.1% 13.1% 9.1% 13.1% 13.1% 9.1% 9.1% BBB- 1.7% 8.7% 1.7% 1.3% 1.7% 1.7% 1.7% 6.7% BB+ 2.% 1.8% 3.8%.% 3.8% 3.8%.%.% BB 1.9% 1.4% 3.%.% 3.4% 1.%.%.% BB- 1.7% 1.%.%.% 3.%.%.%.% Credit high yield B+ 1.8%.8%.%.% 1.1%.%.%.% B 1.%.%.%.%.%.%.%.% B-.8%.%.%.%.%.%.%.% CCC+ 2.1%.2%.2%.2%.2%.2%.2%.2% CCC -.7%.4%.4%.4%.4%.4%.4%.4% CCC- -3.1%.3%.3%.3%.3%.3%.3%.3% Lower -3.1% 1.% 1.% 1.% 1.% 1.% 1.% 1.% OAS 1.2% 1.3% 1.1% 1.3% 1.3% 1.2% 1.1% RBC 1.2% 1.2% 1.2% 1.4% 1.4%.9% 1.2% Duration RoC Source: Barclays, J.P. Morgan, Moody s and PIMCO Figure 11: RoC by rating* AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- Current Proposed *RoC represents the fixed income spread return (in percent) divided by the capital charge (in percent). Hypothetical example for illustrative purposes only. Refer to appendix for additional credit quality, hypothetical example, OAS and return assumptions information. Source: Barclays, J.P.Morgan, Moody s and PIMCO as of 29 September 26 to 31 December 27

16 16 December 216 Quantitative Research Table 11: Detailed allocation to rating buckets with spreads at the post-crisis average (3 January 29 to 31 August 216) Asset class Rating OAS allocation RBC = 1.2% RBC = 1.4% MAX RoC Current Proposed Current Proposed Current Current Treasuries AAA.1% 6.1% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% AAA.9% 12.1% 1.1% 12.9% 1.1% 1.1% 1.1% 14.1% AA+ 1.% 3.6% 1.6%.6% 1.6% 3.4%.6%.6% Credit investment grade AA 1.7% 2.7%.7% 4.7%.7% 4.7% 4.7% 4.7% AA- 1.6%.% 3.% 7.% 3.% 3.% 7.% 7.% A+ 1.7% 6.8% 6.% 8.8% 4.8% 4.8% 8.8% 8.8% A 1.8% 1.7% 12.7% 8.7% 9.3% 8.7% 12.7% 8.7% A- 2.2% 11.4% 13.4% 13.4% 13.4% 13.4% 13.4% 13.4% BBB+ 2.3% 13.4% 1.4% 12.7% 1.4% 1.4% 11.4% 11.4% BBB 2.4% 11.1% 13.1% 9.1% 13.1% 13.1% 9.2% 9.1% BBB- 2.9% 8.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% BB+ 3.7% 1.8% 3.4%.% 3.8% 3.8%.%.% BB 3.9% 1.4% 3.4%.% 3.4% 2.4%.%.% BB- 3.6% 1.%.%.% 3.%.%.%.% Credit high yield B+ 3.7%.8%.%.%.%.%.%.% B 4.%.%.%.% 1.1%.%.%.% B- 3.4%.%.%.%.%.%.%.% CCC+.1%.2%.2%.2%.2%.2%.2%.2% CCC 4.%.4%.4%.4%.4%.4%.4%.4% CCC- 4.6%.3%.3%.3%.3%.3%.3%.3% Lower 6.% 1.% 1.% 1.% 1.% 1.% 1.% 1.% OAS 2.% 2.2% 1.9% 2.2% 2.1% 2.% 1.9% RBC 1.2% 1.2% 1.2% 1.4% 1.4%.9% 1.2% Duration RoC Source: Barclays, J.P. Morgan, Moody s and PIMCO Figure 12: RoC by rating* AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- Current Proposed *RoC represents the fixed income spread return (in percent) divided by the capital charge (in percent). Hypothetical example for illustrative purposes only. Refer to appendix for additional credit quality, hypothetical example, OAS and return assumptions information. Source: Barclays, J.P. Morgan, Moody s and PIMCO as of 3 January 29 to 31 August 216

17 December 216 Quantitative Research 17 Table 12: Detailed allocation to rating buckets with spreads at the crisis level (as of 3 November 28) Asset class Rating OAS allocation RBC = 1.2% RBC = 1.4% MAX RoC Current Proposed Current Proposed Current Current Treasuries AAA.% 6.1% 4.1% 8.1% 4.1% 4.1% 4.2% 8.1% AAA.6% 12.1% 1.1% 14.1% 1.1% 13.% 1.1% 14.1% AA+ 1.2% 3.6% 1.6%.6% 1.6%.6%.6%.6% Credit investment grade AA 1.3% 2.7%.7% 4.7%.7% 4.7% 4.7% 4.7% AA- 1.4%.% 6.% 7.% 3.% 7.% 7.% 7.% A+ 1.% 6.8% 8.8% 8.7% 8.6% 4.8% 8.8%.% A 1.% 1.7% 12.7% 8.7% 12.7% 8.7% 12.7% 8.7% A- 1.7% 11.4% 13.4% 9.4% 13.4% 9.4% 13.4% 9.4% BBB+ 2.2% 13.4% 11.4% 11.4% 11.4% 11.4% 11.4% 11.4% BBB 2.3% 11.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% BBB- 3.1% 8.7% 1.7% 6.7% 1.7% 1.7% 1.7% 6.7% BB+ 6.2% 1.8% 2.1% 3.8% 3.8% 3.8%.% 3.8% BB 7.1% 1.4% 3.4%.3% 3.4% 3.4%.% 3.4% BB- 7.7% 1.% 3.%.% 3.%.%.%.% Credit high yield B+ 8.6%.8%.%.%.% 1.4%.%.% B 11.%.%.%.%.%.%.%.% B- 11.4%.%.%.% 1.9%.%.%.% CCC+ 16.3%.2%.2%.2%.2%.2%.2%.2% CCC 23.6%.4%.4%.4%.4%.4%.4%.4% CCC- 3.3%.3%.3%.3%.3%.3%.3%.3% Lower 47.4% 1.% 1.% 1.% 1.% 1.% 1.% 1.% OAS 2.9% 3.1% 2.6% 3.4% 3.% 2.6% 2.8% RBC 1.2% 1.2% 1.2% 1.4% 1.4%.9% 1.3% Duration RoC Source: Barclays, J.P. Morgan, Moody s and PIMCO Figure 13: RoC by rating* AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- Current Proposed *RoC represents the fixed income spread return (in percent) divided by the capital charge (in percent). Hypothetical example for illustrative purposes only. Refer to appendix for additional credit quality, hypothetical example, OAS and return assumptions information. Source: Barclays, J.P. Morgan, Moody s and PIMCO as of 3 November 28

18 18 December 216 Quantitative Research A.6. Spread environment in which high yield can become favorable For investment grade, we keep the default-adjusted spreads as of 29 July 216, and for high yield we double the non-default-adjusted spreads as return expectations. Table 13: Detailed allocation to rating buckets (as of 29 July 216) Asset class Rating OAS allocation RBC = 1.2% RBC = 1.4% MAX RoC Current Proposed Current Proposed Current Current Treasuries AAA.% 6.1% 4.1% 8.1% 4.1% 4.1% 4.2% 8.1% AAA.6% 12.1% 1.1% 14.1% 1.1% 13.% 1.1% 14.1% AA+ 1.2% 3.6% 1.6%.6% 1.6%.6%.6%.6% Credit investment grade AA 1.3% 2.7%.7% 4.7%.7% 4.7% 4.7% 4.7% AA- 1.4%.% 6.% 7.% 3.% 7.% 7.% 7.% A+ 1.% 6.8% 8.8% 8.7% 8.6% 4.8% 8.8%.% A 1.% 1.7% 12.7% 8.7% 12.7% 8.7% 12.7% 8.7% A- 1.7% 11.4% 13.4% 9.4% 13.4% 9.4% 13.4% 9.4% BBB+ 2.2% 13.4% 11.4% 11.4% 11.4% 11.4% 11.4% 11.4% BBB 2.3% 11.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% BBB- 3.1% 8.7% 1.7% 6.7% 1.7% 1.7% 1.7% 6.7% BB+ 6.2% 1.8% 2.1% 3.8% 3.8% 3.8%.% 3.8% BB 7.1% 1.4% 3.4%.3% 3.4% 3.4%.% 3.4% BB- 7.7% 1.% 3.%.% 3.%.%.%.% Credit high yield B+ 8.6%.8%.%.%.% 1.4%.%.% B 11.%.%.%.%.%.%.%.% B- 11.4%.%.%.% 1.9%.%.%.% CCC+ 16.3%.2%.2%.2%.2%.2%.2%.2% CCC 23.6%.4%.4%.4%.4%.4%.4%.4% CCC- 3.3%.3%.3%.3%.3%.3%.3%.3% Lower 47.4% 1.% 1.% 1.% 1.% 1.% 1.% 1.% OAS 2.9% 3.1% 2.6% 3.4% 3.% 2.6% 2.8% RBC 1.2% 1.2% 1.2% 1.4% 1.4%.9% 1.3% Duration RoC Figure 14: RoC by rating* 7 Current Proposed *RoC represents the fixed income spread return (in percent) divided by the capital charge (in percent). Hypothetical example for illustrative purposes only. Refer to appendix for additional credit quality, hypothetical example, OAS and return assumptions information. Source: Barclays, J.P. Morgan, Moody s and PIMCO as of 3 January 1 29 to 29 July 216 AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B-

19

20 Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Certain U.S. government securities are backed by the full faith of the government. 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