The Role of Equities and Alternative Assets in P&C Insurance Portfolios

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1 In Depth January 2014 Your Global Investment Authority The Role of Equities and Alternative Assets in P&C Insurance Portfolios Ahmet E. Kocagil, Ph.D. Executive Vice President Client Analytics and Global Head of Financial Institution Analytics Introduction Property and Casualty (P&C) Insurance companies in the United States invest heavily in fixed income products. In the current low-rate environment, many insurers have been trying to boost their portfolio yield by lowering the credit quality of their corporate portfolio and by exploring opportunities in new asset classes, such as hedge funds and private equity. At the same time, insurance companies must manage the total capital requirements on their portfolios. Within the industry, there is a view that the regulatory cost of alternative assets is prohibitively expensive. In this study, we seek to demonstrate that investments in equities and alternatives are notably less capital intensive than their stand-alone regulatory charges might suggest. We examine the desirability of a marginal increase in equities and alternatives given the current average asset allocation (in unaffiliated investments) for P&C companies and PIMCO s forward looking views on returns. Taking into account both regulatory capital and overall investment risk, we find that alternative assets are an attractive option for the P&C insurance industry. Average asset allocation for P&C insurance companies Insurance companies in the United States are required to disclose security-level detail on their complete investment portfolio on a quarterly basis. This allows for a detailed analysis of their asset allocation, including risk characteristics such

2 as security duration and regulatory capital charges. In this paper, we utilize CUSIP-level investment portfolio holdings as of June 2013 for all property and casualty insurance companies with over ten billion dollars in cash and investments. 1 The resulting sample consists of 25 large insurance firm portfolios, which account for nearly two-thirds of the entire industry s unaffiliated investment holdings. 2 To analyze the P&C industry as a whole, we aggregate securitylevel data from these 25 portfolios into representative asset classes. The market-value weighted asset allocation for the property and casualty sector is shown in Figure 1. FIGURE 1: AVERAGE ASSET ALLOCATION FOR TOP 25 PROPERTY AND CASUALTY INSURERS P&C Universe International 3% Other 0% Regulatory capital cost calculation for U.S. P&C insurance companies Insurance companies in the United States are regulated by the National Association of Insurance Commissioners (NAIC). Firms are required to hold a certain amount of regulatory capital (risk-based capital or RBC ) that is based on a supervisory assessment of the risks within their investment portfolio, their insurance underwriting practices, as well as several other factors. Insurance companies often hold capital well in excess of the regulatory minimums to account for potential outflows. The NAIC proscribes an algorithm to determine total capital requirements as well as capital thresholds that trigger specific regulatory interventions. For property and casualty (P&C) insurers, the final RBC formula calculates total required capital as a combination of six subcategories of risk: (1) Non-Agency structured 8% Agency/Agency MBS 9% Treasuries and TIPS 7% Equities and alternatives 14% Corporate bonds 25% Municipal 33% Where R 0 is the applicable charge for investments in affiliates and subsidiaries, R 1 is the charge for the fixed income portion of the investment portfolio, R 2 is the charge for the equities and alternatives portion of the investment portfolio, R 3 is for the credit risk in receivables such as reinsurance, R 4 is for their underwriting risk reserves and R 5 for underwriting risk on net written premiums. The marginal effect of changes in any single charge on a firm s total capital requirements is related to the other regulatory capital charges, as follows: (2) Source: PIMCO, SNL Financial Each of these categories (from R 1 to R 5 ) has its own calculation methodology and associated exceptions and adjustments. The fixed income portfolio (R 1 ) base charges for P&C insurers by NAIC rating are shown in the following table: 3 2 JANUARY 2014 IN DEPTH

3 TABLE 1: BASELINE RBC CHARGES: P&C INSURERS NAIC rating Federal government bonds or bonds explicitly guaranteed by the federal government Cash, non-government money market funds Equivalent rating RBC charge - 0.0% - 0.3% NAIC 1 A 0.3% NAIC 2 BBB 1.0% NAIC 3 BB 2.0% NAIC 4 B 4.5% NAIC 5 C 10.0% NAIC 6/default D 30.0% Source: NAIC For P&C companies, the baseline R 2 charge, which covers common stocks, ETFs, mutual funds and many alternatives ( equity/alts for short) is 15%: higher than the charge for any non-defaulted bond. This base charge has led many in the insurance industry to maintain a very low allocation in these investments or to avoid them altogether. However, our analysis shows that the marginal or effective equities and alternatives charge is lower often substantially lower than the 15% baseline, as the regulatory covariance adjustment (Equation 1) implicitly assumes the risk categories (R 1 to R 5 ) are uncorrelated. Empirical findings on regulatory cost calculations In this section, we estimate the marginal change in RBC requirements from incremental changes in the allocation to equities and alternatives for every insurer in our sample: We first calculate the R 1 and R 2 charges for each P&C company in our universe from the security level holdings in their investment portfolio. We then assume that a fraction of the total regulatory capital is due to affiliates (R 0 ). NAIC research (Property & Casualty Industry RBC Results for 2011) shows that R 0 charges typically fluctuate between 10% and 15%. For simplicity we assume that 10% of the total RBC charge comes from affiliates (this assumption does not materially impact subsequent calculations). Given an R 0 charge, we then use Equation 1 along with the total reported RBC for each firm, to infer the total unadjusted regulatory capital due to underwriting and receivables (R R 4 + R 5 ). We then estimate the total effect of additional investments in equities and alternatives on RBC assuming that they are funded evenly from the existing fixed income portfolio. We call the total change in RBC due to a marginal increase in the equities and alternatives allocation the net effective equity charge. 4 Figure 2 contains the distribution of estimated net effective equity charges for the firms in our sample. FIGURE 2: DISTRIBUTION OF NET EFFECTIVE EQUITY CHARGES FOR TOP P&C FIRMS Percent of companies Frequency of net effective equity charges vs. baseline charge 0 0% 2% 4% 6% 8% 10% 12% 14% 16% Source: PIMCO Net effective equity charge All firms in the sample have a net effective equity charge that is notably lower than the baseline charge (15%), and the modal firm s effective equity charge is only two percent. This translates to an effective capital discount of 87% from the baseline charges. Asset allocation with additional equities and alternatives The substantial discounts provided by the covariance adjustment suggest that insurers may benefit from incremental IN DEPTH JANUARY

4 investments in equities and alternatives without significant additional capital costs. In this section, we allow our representative insurer to make a five percentage point investment in the equities and alternatives portfolio funded from the fixed income portion of the portfolio and we optimize the portfolio s asset allocation maintaining the increased allocation to equities and alternatives. For this optimization, we specify the following parameters and constraints: We employ PIMCO s forward-looking assumptions governing asset level returns; We impose constraints on investment allocations, duration (to maintain an assumed duration-match with the liabilities) and regulatory capital; We minimize tail risk (measured by the 95 th percentile CVaR) 5. We evaluate the optimal asset allocations with and without this additional investment in alternatives. The appendix contains the details of the optimization process, including all return assumptions and constraints. FIGURE 3: OPTIMAL ALLOCATIONS WITH INCREMENTAL EQUITIES AND ALTERNATIVES Expected return (%) Optimal allocations % 2% 4% 6% 8% 10% 12% Source: PIMCO All constraints Optimal (5% more equities and alternatives) Current allocation Conditional value at risk (95%) With 5% more equities and alternatives Optimal allocation Hypothetical example for illustrative purposes only. Current allocation as well as optimal allocations are detailed in Appendix, Table A2. Optimal allocation is based on PIMCO calculations using Appendix, Table A2 and A3. "Optimal (5% more equities and alternatives)" allows for a reallocation of 5% of the portfolio into equities and alternatives from fixed income products. Portfolio estimated returns were calculated using the median estimated return assigned to each index in Appendix, Table A2. To calculate the estimated volatility and CVAR, we proxy each asset class using the portfolio holdings of the indexes provided in Table A2. To calculate the estimated volatility we employed a block bootstrap methodology. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 15,000 times to have a return series with 15,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. CVaR is an estimate of the minimum expected loss at a desired level of significance. Transaction costs (such as commissions or other fees) are not included in the calculation of returns reflected. If these fees and charges were included the performance results would be lower. Figure is for illustrative purposes and is not indicative of the past or future performance of any PIMCO product. The attainable efficient frontier realized by increasing the allocation to alternatives and equities can be found in Figure 3. In the chart, the black point represents the current allocation of the market-value weighted representative insurance portfolio; the light blue point indicates the risk-adjusted optimal portfolio holding the equities and alternatives allocation constant; and the dark-blue point displays the optimal portfolio allowing additional investments into equities and alternatives. The optimal allocations with additional alternatives investments are shown in Table 2. In the optimal portfolio, we estimate that P&C insurers would decrease their allocation to Agency MBS and international bonds, and increase it for corporates, municipals and non- Agency structured finance securities. The new portfolio is estimated to yield 69 bps in additional returns, holding the tail risk constant. Given the size of the unaffiliated investment portfolios across the P&C insurance industry, this translates, based on the modeling of our hypothetical insurer portfolio, to an additional $7.8 billion in industry-wide annual returns. We find that alternatives are heavily favored due to increased diversification benefits in the representative P&C insurance portfolio relative to equities alone. Our results suggest increasing the combined weight of alternatives from 3% to 10%, and actually reducing the plain equity exposure in the portfolio, despite an overall increase in the total allocation to equities and alternatives as a category. 4 JANUARY 2014 IN DEPTH

5 TABLE 2: OPTIMAL ASSET ALLOCATIONS WITH ADDITIONAL INVESTMENTS IN EQUITIES AND ALTERNATIVES: Current allocation 3% 0% 9% 8% 13% 7% 25% 33% +5% Equities and alternatives 2% 0% 0% Municipal Corporate bonds Equities and alternatives Agency/Agency MBS Non-Agency structured Treasuries and TIPS International Other Asset class Current 4% 18% 11% 30% 34% Optimal w/+5% equities and alternatives Estimated return 3.4% 4.1% Estimated 95% CVaR 7.9% 7.9% Estimated YTM 3.3% 3.8% Estimated duration Alternatives 3.0% 10.0% Equities 11.0% 8.0% Capital ratio 315.0% 309.0% Source: PIMCO, SNL Financial Hypothetical example for illustrative purposes only. Current allocation as well as optimal allocations are detailed in Appendix, Table A2. Optimal allocation is based on PIMCO calculations using Appendix, Table A2 and A3. "Optimal (5% more equities and alternatives)" allows for a reallocation of 5% of the portfolio into equities and alternatives from fixed income products. Differences in the displayed 5% equities and alternatives allocation is due to rounding. Portfolio estimated returns were calculated using the median estimated return assigned to each index in Appendix, Table A2. To calculate the estimated volatility and CVAR, we proxy each asset class using the portfolio holdings of the indexes provided in Table A2. To calculate the estimated volatility we employed a block bootstrap methodology. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 15,000 times to have a return series with 15,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. CVaR is an estimate of the minimum expected loss at a desired level of significance. Transaction costs (such as commissions or other fees) are not included in the calculation of returns reflected. If these fees and charges were included the performance results would be lower. Figure is for illustrative purposes and is not indicative of the past or future performance of any PIMCO product. As alternatives have higher capital charges, one would expect that increasing the alternatives allocation increases total RBC 6 charges slightly. We estimate that the total capital ratio, which is inversely related to RBC 7, would decline from 315% to 309% for the average firm in the analysis and that the median firm would have to increase capital by 0.9% to retain their original capital ratio. Of course, these are only summary estimates. The firms with the largest covariance benefits in our sample only require 0.13% 0.30% additional capital (as opposed to 0.90% for the median firm) to retain the same capital ratio: we estimate that these firms would potentially experience a tail-risk-adjusted increase of bps in net returns (assuming a cost of capital in the 6% 12% range) by reallocating 5% of their fixed income portfolio to alternatives. Once the covariance adjustment is taken into account, firms in our sample are likely to see increases in risk and regulatory capital-adjusted estimated returns by increasing their allocation to alternatives. Conclusion In this paper, we analyze the P&C Insurance industry investment portfolio using market-value weighted security-level holdings of the largest P&C Insurance firms (with assets in excess of $10 billion). Examining the regulatory capital charges for the firms in the sample, we observe that: The insurance companies in the sample face effective charges for equities and alternatives that are notably lower than the baseline value, This discount increases for firms with portfolios that have relatively higher non-investment portfolio regulatory capital charges, By adding or increasing exposure to equities and alternatives P&C insurers can potentially realize non-negligible enhancements in expected portfolio returns net of additional capital costs for a reasonable range of cost of capital. IN DEPTH JANUARY

6 Appendix A.1 List of firms included in the analysis The following firms are included in the P&C firm universe. According to year-end 2012 regulatory filings, this represents all P&C firms with investment portfolios greater than $10 billion, excluding Berkshire Hathaway. These firms represent over 60% of the total unaffiliated assets of the P&C industry excluding Berkshire Hathaway. Every firm is analyzed at the group level. TABLE A1: LIST OF FIRMS INCLUDED IN THE ANALYSIS Firm ACE Ltd. (SNL P&C Group) Alleghany Corp. (SNL P&C Group) Allianz Group (SNL P&C Group) Allstate Corp. (SNL P&C Group) American Family Mutual (SNL P&C Group) American International Group (SNL P&C Group) Auto-Owners Insurance Co. (SNL P&C Group) Chubb Corp. (SNL P&C Group) CNA Financial Corp. (SNL P&C Group) Erie Insurance Group (SNL P&C Group) Fairfax Financial Holdings (SNL P&C Group) Farmers Insurance Group of Cos (SNL P&C Group) FM Global (SNL P&C Group) Hartford Financial Services (SNL P&C Group) Liberty Mutual (SNL P&C Group) Munich-American Holding Corp. (SNL P&C Group) Nationwide Mutual Group (SNL P&C Group) Progressive Corp. (SNL P&C Group) State Farm Mutl Automobile Ins (SNL P&C Group) Swiss Re Ltd. (SNL P&C Group) Tokio Marine Group (SNL P&C Group) Travelers Companies Inc. (SNL P&C Group) USAA Insurance Group (SNL P&C Group) W. R. Berkley Corp. (SNL P&C Group) Zurich Insurance Group Ltd. (SNL P&C Group) Source: SNL Financial A.2 Optimization in a risk factor based framework PIMCO has developed a platform to analyze and optimize portfolios in the presence of investment constraints and assumptions regarding future returns, volatilities and correlations. Given any investment portfolio and corresponding benchmark indices, PIMCO generates regime-based estimates of volatilities and correlations for underlying risk factors, alongside forward-looking estimates of expected returns from their internal capital markets assumption process. This framework is discussed in detail in a previous paper ( Portfolio Optimization in an Evolving Regulatory Environment: An Application to U.S. Bank Available for Sale Portfolios, PIMCO Quantitative Research, June 2013). The relevant aspects of the analysis are the following: Optimization and Tail Risk: Typical portfolio optimization routines generate mean-variance efficient portfolio allocations. However, capital requirements and investment risks at financial institutions such as P&C insurers are generally based on periods of extreme loss. To this end, we calculate a series of mean-tail risk efficient portfolios that minimize tail losses as defined by the conditional value at risk (CVaR) at the 95 th percentile. Asset return assumptions: On a biannual basis, PIMCO reviews its views on expected returns for a wide range of global asset classes. This process is based on a combination of historical data, valuations, model-based forecasts and trade desk views by specialists. We map the marketweighted P&C insurance allocation portfolio to benchmark indices based on security-level information on asset class and estimated duration. The mapping of the market weighted average insurance portfolio to asset specific benchmarks and the corresponding return assumptions can be found below (as of Q3 2013): 6 JANUARY 2014 IN DEPTH

7 TABLE A2: RETURN ASSUMPTIONS AND ASSET MAPPING Index Assigned asset class Range of estimated 10Y returns (pre-tax) Current allocation Optimal Optimal + 5% equities and alternatives Barclays Fixed-Rate MBS Index Agency/Agency MBS 2.1% to 2.5% 6.69% 3.93% 3.93% Barclays Long-Term Treasury Index Treasuries and TIPS 2.3% to 3.5% 1.17% 0.00% 0.00% Barclays U.S. Treasury Index Treasuries and TIPS 1.9% to 2.3% 0.40% 0.00% 0.00% JPMorgan GBI Global ex-us USD Hedged International/EM 2.1% to 2.5% 2.16% 0.00% 0.00% Barclays U.S. TIPS:1-10 Yr Index Treasuries and TIPS 2.5% to 2.9% 0.23% 8.42% 2.01% Barclays 1 Yr Muni Index Municipal 1.6% to 2.0% 9.83% 0.00% 0.00% CSFB Leveraged Loan Index High yield/bank loans 3.1% to 3.5% 0.55% 0.00% 0.00% 3 Month USD Libor Index Other 1.1% to 1.5% 0.27% 0.00% 0.00% Barclays Asset-Backed Securities Index ABS 2.3% to 2.7% 2.74% 0.00% 0.00% Barclays Long Muni Index Municipal 2.8% to 3.6% 11.99% 30.03% 34.48% Barclays US TIPS Index > 10 yrs Treasuries and TIPS 3.0% to 3.8% 0.67% 0.00% 0.00% JPMorgan EMBI Global International/EM 4.0% to 4.8% 1.32% 0.00% 0.00% Barclays Municipal Bond 1-10 Year Blend Municipal 2.3% to 2.7% 11.39% 0.00% 0.00% Barclays Capital Long Corp Index Corporate Bonds 3.1% to 4.7% 11.12% 0.00% 0.00% BofA ML 1-5 Year US TIPS Treasuries and TIPS 2.1% to 2.5% 0.21% 0.00% 0.00% 6 Month US T-bill Treasuries and TIPS 1.1% to 1.5% 4.33% 0.00% 0.00% Barclays US Corporate 3-5 Yrs Corporate Bonds 2.8% to 3.2% 11.53% 27.65% 25.86% MARKIT PRIMEX.ARM.1 6/36 Non-Agency structured 3.9% to 4.7% 2.29% 2.53% 2.96% Barclays US High Yield 1-3 Yr High yield/bank loans 3.5% to 3.9% 0.00% 0.00% 0.00% Barclays US High Yield 5-10 Yr High yield/bank loans 4.1% to 5.3% 0.31% 0.00% 0.00% Barclays US High Yield 10+ Yr High yield/bank loans 5.3% to 6.9% 1.70% 5.58% 3.90% Barclays CMBS Yr Non-Agency structured 3.2% to 3.6% 0.00% 8.39% 8.39% Barclays US Agency 1-5 years Agency/Agency MBS 1.8% to 2.2% 2.25% 0.00% 0.00% Barclays Global Agg Covered 1-3 Yrs International/EM 0.0% to 0.4% 0.00% 0.00% 0.00% Barclays CMBS Yr CMBS 3.1% to 3.9% 3.39% 0.00% 0.00% S&P 500 Index with constituents Equity 4.8% to 6.4% 10.63% 10.63% 8.47% HFRI Fund Weighted Comp Index/Cambridge Associates US Private Equity Index (50%/50%) Alts 6.4% to 7.6% 2.84% 2.84% 10.00% Source: PIMCO Current allocation is the average asset allocation (in unaffiliated investments) for P&C companies. Estimated return range assigned to each index based on a combination of methods of pulling together historical data, valuation metrics and qualitative inputs based on PIMCO's secular views. Transaction costs (such as commissions or other fees) are not included in the calculation of returns reflected. If these fees and charges were included the performance results would be lower. Figure is for illustrative purposes and is not indicative of the past or future performance of any PIMCO product. IN DEPTH JANUARY

8 Note that municipal bonds are a prominent portion of P&C insurance portfolios, which is partially driven by the tax benefits offered by this asset class. To account for the tax advantage in the optimization process, estimated municipal bond total returns (1.6% 2% for the Barclays 1 Yr. Muni Index) are adjusted to incorporate their favorable tax treatment. The price appreciation component of the total return is left untouched (as they are subject to capital gains taxes), whereas the yield portion of municipal bond returns (obtained from benchmark returns) is tax-adjusted based on the 2013 estimate of effective corporate tax rates as estimated by the United States Government Accountability Office (For more information on this estimate, please consult GAO Publication ). Investment constraints: Investment committees and boards of directors often provide guidelines that restrict excessive allocations to particular asset classes in an attempt to manage risk. Moreover, absent dramatic changes in the marketplace, it is prohibitively expensive to conduct large rebalancing exercises year to year with each incremental reassessment of future risks. In this analysis, we incorporate this reality by restricting optimal portfolio allocations to lie within a relatively compact neighborhood of the initial allocation. In particular, we require each asset class to fluctuate within +/- 5 percentage points of the current allocation, and do not allow short exposures. The expanded list of asset classes, the current allocation, and minimum and maximum permissible allocations are shown in Table 2. In addition to investment limits on their asset allocation, insurance portfolios are typically managed to match certain risk characteristics. These are often related to the drivers of the discounted value of projected liability and policy payments, such as total portfolio duration. To ensure that we retain desirable risk characteristics, and assuming that their current durations are near their target durations we require the total estimated duration to remain within three months of the current value. 8 Regulatory Capital: We estimate a baseline fixed income regulatory capital charge for each benchmark index, and require that the optimal portfolio does not require more capital than the current allocation. As total RBC is monotonic with respect to the R 1 charge, a linear constraint on the asset allocation based on the baseline RBC charges for each asset class is sufficient to implement this constraint. TABLE A3: FIXED INCOME ASSET ALLOCATION CONSTRAINTS Assigned asset class Minimum Current Maximum ABS 0.0% 2.7% 7.7% Agency/Agency MBS 3.9% 8.9% 13.9% CMBS 0.0% 3.4% 8.4% High yield/bank loans 0.0% 2.6% 7.6% Corporate bonds 17.7% 22.7% 27.7% International/EM 0.0% 3.5% 8.5% Municipal 28.2% 33.2% 38.2% Non-Agency structured 0.0% 2.3% 7.3% Treasuries and TIPS 2.0% 7.0% 12.0% Equities and alternatives 13.5% 13.5% 18.5% Other 0.0% 0.3% 5.3% Source: PIMCO Minimum and maximum allocations are Intended for study purposes only and should not be considered a recommendation 8 JANUARY 2014 IN DEPTH

9 1 Due to idiosyncrasies in their investment strategy, we exclude Berkshire Hathaway from this analysis. 2 For a full list of firms considered in this paper, please consult the Appendix. 3 The R 1 charges contain issuer and concentration adjustments on top of the baseline charges depicted in Table I. We include these when we calculate aggregate risk-based capital in the next section, though we largely ignore them throughout this study as asset allocation recommendations are distinct from the number of securities or the distribution of values across securities. As such, we assume that fixed income to equities and alternatives reallocations will not substantively alter the total magnitude of the issuer and concentration adjustments within the fixed income portfolio. 4 More formally, we have: where w is the portfolio allocation to equities and alternatives and R i* is the normalized capital charge per percentage point invested the relevant asset class. 5 Conditional Value at Risk represents the expected portfolio losses conditional on losses exceeding a certain threshold. In this case 95% CVAR represents the expectation of loss conditional on loss exceeding a 95th percentile event. It is therefore more extreme than the 95th percentile VAR which is a one-in-twenty loss. Further details on the implementation of this measure can be found in Portfolio Optimization in an Evolving Regulatory Environment (PIMCO, June 2013). 6 The optimization process suggests that when equity/alternatives portfolio is awarded additional funding alternative assets are relatively more attractive than simple equity exposures. This is due to two facts: alternative assets have more diverse risk exposures, and they offer slightly higher estimated returns with identical regulatory capital treatment. (Please consult Table A2 in the appendix for more information). 7 Capital ratio is defined as total capital over RBC. 8 Evaluation of the optimal level of duration would necessitate data on insurance companies liabilities, which is beyond the current scope of this paper. 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 certain risks, including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Investing in foreigndenominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision. Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over the long term. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No representation is being made that the structure of the average portfolio or any account will remain the same or that similar returns will be achieved. The analysis may not be attained and should not be construed as the only possibilities that exist. Different weightings in the asset allocation illustration will produce different results. Actual results will vary and are subject to change with market conditions. There is no guarantee that results will be achieved. No fees or expenses were included in the estimated results and distribution. The scenarios assume a set of assumptions that may, individually or collectively, not develop over time. The analysis reflected in this information is based upon data at time of analysis. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. PIMCO routinely reviews, modifies, and adds risk factors to its proprietary models. Due to the dynamic nature of factors affecting markets, there is no guarantee that simulations will capture all relevant risk factors or that the implementation of any resulting solutions will protect against loss. Simulated risk analysis contains inherent limitations and is generally prepared with the benefit of hindsight. Realized losses may be larger than predicted by a given model due to additional factors that cannot be accurately forecasted or incorporated into a model based on historical or assumed data. We employed a block bootstrap methodology to calculate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 15,000 times to have a return series with 15,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. Value at Risk (VAR) estimates the risk of loss of an investment or portfolio over a given time period under normal market conditions in terms of a specific percentile threshold of loss (i.e., for a given threshold of X%, under the specific modeling assumptions used, the portfolio will incur a loss in excess of the VAR X percent of the time. Different VAR calculation methodologies may be used. VAR models can help understand what future return or loss profiles might be. However, the effectiveness of a VAR calculation is in fact constrained by its limited assumptions (for example, assumptions may involve, among other things, probability distributions, historical return modeling, factor selection, risk factor correlation, simulation methodologies). It is important that investors understand the nature of these limitations when relying upon VAR analyses. The Barclays U.S. MBS Fixed Rate Index covers the mortgage-backed pass through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The MBS Index is formed by grouping the universe of over 600,000 individual fixed rate MBS pools into approximately 3,500 generic aggregates. Barclays Long-Term Treasury Index consists of U.S. Treasury issues with maturities of 10 or more years. The Barclays U.S. Treasury Index is a measure of the public obligations of the U.S. Treasury. The JPMorgan Government Bond Indices Global ex-us Index Hedged in USD is an unmanaged index representative of the total return performance in U.S. dollars of major non-u.s. bond markets. Barclays U.S. TIPS: 1-10 Year is an unmanaged index market comprised of U.S. Treasury Inflation Protected securities having a maturity of at least 1 year and less than 10 years. Barclays 1 Year Municipal Bond Index is an unmanaged index comprised of national municipal bond issues having a maturity of at least one year and less than two years. The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the $U.S.-denominated leveraged loan market. The index inception is January The index frequency is monthly. New loans are added to the index on their issuance date if they qualify according to the following criteria: Loans must be rated 5B or lower; only funded term loans are included; the tenor must be at least one year; and the Issuers must be domiciled in developed countries (Issuers from developing countries are excluded). IN DEPTH JANUARY

10 Fallen angels are added to the index subject to the new loan criteria. The 3-Month LIBOR (London Interbank Offered Rate) Index is an average interest rate, determined by the British Bankers Association, that banks charge one another for the use of short-term money (3 months) in England s Eurodollar market. Barclays Asset-Backed Securities Index has 5 subsectors: credit and charge cards, autos, home equity loans, utility, and manufactured housing. The index includes pass-through, bullet, and controlled amortization structures. It includes only the senior class of each ABS issue; subordinate tranches are not included. Barclays Long Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. Barclays U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $250 million par amount outstanding. Performance data for this index prior to 10/97 represents returns of the Barclays Inflation Notes Index. The JPMorgan Emerging Markets Bond Index Global is an unmanaged index which tracks the total return of U.S.-dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady Bonds, loans, Eurobonds, and local market instruments. The Barclays 1-10 Year Municipal Bond Index is an unmanaged index considered to be generally representative of investment-grade municipal issues having remaining maturities from 1-10 years and a national scope. The Barclays Long Corporate Index is a component of the Barclays U.S. Long Credit index. Barclays U.S. Long Credit Index is the credit component of the Barclays US Government/Credit Index, a widely recognized index that features a blend of US Treasury, government-sponsored (US Agency and supranational), and corporate securities limited to a maturity of more than ten years. The BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index SM is an unmanaged index comprised of U.S. Treasury Inflation Protected Securities with at least $1 billion in outstanding face value and a remaining term to final maturity of at least 1 year and less than 5 years. The Barclays U.S. Corporate Index covers USD-denominated, investment-grade, fixed-rate, taxable securities sold by industrial, utility and financial issuers. It includes publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity, and quality requirements. Securities in the index roll up to the U.S. Credit and U.S. Aggregate indices. The U.S. Corporate Index was launched on January 1, The Markit PrimeX Index tracks non-agency prime U.S. residential mortgage-backed securities. The index has four sub-indices comprised of 20 deals each, referencing fixed rate or hybrid ARM non-agency prime loans from 2005, 2006, and The Barclays High Yield Index is an unmanaged market-weighted index including only SEC registered and 144(a) securities with fixed (non-variable) coupons. All bonds must have an outstanding principal of $100 million or greater, a remaining maturity of at least one year, a rating of below investment grade and a U.S. Dollar denomination. The Barclays Commercial Mortgage-Backed Securities Index is an unmanaged index comprised of the CMBS Investment-Grade Index, CMBS High-Yield Index, CMBS Interest-Only Index, and Commercial Conduit Whole Loan Index (all bond classes and interest-only classes). The Barclays U.S. Agency Index includes native currency agency debentures (Fannie Mae, Freddie Mac, and Federal Home Loan Bank), and includes both callable and non-callable agency securities issued by U.S. government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. government. Barclays Global Aggregate Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The HFRI Equity Hedge index is an unmanaged index that consists of a core holding of long equities hedged at all times with short sales of stocks and/or stock index options. Some managers maintain a substantial portion of assets within a hedged structure and commonly employ leverage. Where short sales are used, hedged assets may be comprised of an equal dollar value of long and short stock positions. Other variations use short sales unrelated to long holdings and/or puts on the S&P 500 index and put spreads. Conservative funds mitigate market risk by maintaining market exposure from zero to 100 percent. Aggressive funds may magnify market risk by exceeding 100 percent exposure and, in some instances, maintain a short exposure. In addition to equities, some funds may have limited assets invested in other types of securities. It is not possible to invest directly in an unmanaged index. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA is regulated by the United States Securities and Exchange Commission. 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PIMCO Asia Limited (24th Floor, Units 2402, 2403 & 2405 Nine Queen s Road Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. PIMCO Australia Pty Ltd (Level 19, 363 George Street, Sydney, NSW 2000, Australia), AFSL and ABN , offers services to wholesale clients as defined in the Corporations Act PIMCO Japan Ltd (Toranomon Towers Office 18F, , Toranomon, Minato-ku, Tokyo, Japan ) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and Investment Trusts Association. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1o andar, Rio de Janeiro RJ Brasil No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. 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