Martha Leiper Senior Vice President & Deputy Chief Investment Officer

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1 Investment Strategies Corporate Level Martha Leiper Senior Vice President & Deputy Chief Investment Officer Southeastern Actuaries Conference November 21, 2008

2 Table of Contents Current Environment The Lead-In CDOs Relevance to Insurance Investments Lessons Learned Opportunities Outlook 1

3 Current Environment The seizing up of the credit markets since mid-september has caused the economic outlook to deteriorate. Question: Is the US economy in a recession? Answer: Recent economic data suggest it began last quarter. 3Q GDP falls.3% as housing and auto weakness spread to other areas of the economy. Consumer spending declines for the first time since ISM manufacturing index plunges into a range consistent with recessionary slowdown. October export orders are weakest in two decades. Job losses accelerate. 2

4 Current Environment Housing at the epicenter of the financial crisis, shows no sign of stabilizing. Housing Starts Thousands, seasonally adjusted annual rate 2,400 2,000 1,600 1, '75 '80 '85 '90 '95 '00 '05 Source: Census Bureau, FactSet, EcoWin, JPMorgan Asset Management. Data reflects most recently available as of 9/30/08. Home price based on median sales price of existing homes and arecumulative, not annualized. Existing-home sales include single-family, townhomes, condominiums and co-ops. In October, single family housing starts hit a 26-year low. Housing prices continued to decline. 3

5 Current Environment Manufacturing previously the bright spot in the US economy is showing weakness. Manufacturing in the US contracted in October at the fastest pace in 26 years. Exports have weakened as economies abroad falter. 4

6 Current Environment Consumer sentiment turns negative. Consumer Sentiment Index - University of Michigan Source: JPMorgan Including subsequent S&P 500 Index 12-month return Consumer Sentiment Low x% S&P 500 Return Over Next 12-mo s Employment - Total Non-farm Payroll Total job gain/loss (thousands) /31/ % 10/31/05 10/31/ % 2/28/75 5/30/ % +22.2% +18.1% '75 '80 '85 '90 '95 '00 ' CSI drops 12.7 points in October. Delinquency Rates All banks, seasonally adjusted 4.5% Source: JPMorgan 4.3% 4.0% Consumer Loans (non -mortgage) 3.5% 3.6% 3.0% 2.5% Residential Mortgages 2.0% 1.5% 1.0% '92 '94 '96 '98 '00 '02 '04 '06 ' Avg. monthly job loss in 08: -76,000 '00 '01 '02 '03 '04 '05 '06 '07 '08 Source: BLS, JPMorgan Asset Management. Data reflects most recently available as of 9/30/08. Labor market has weakened. Delinquency rates trend higher. 5

7 Current Environment - Financial Markets Remain Extremely Volatile The destruction in shareholder wealth over the past 2 months has been dramatic. S&P 500 Index 1,600 Mar. 24, 2000 P/E (tr) = ,527 March 2000 Peak vs. Today: Characteristic 3/2000 9/2008 Oct. 9, 2007 P/E (tr) = ,565 1,400 Index Level 1,527 1,166 P/E Ratio (tr) 30.9x 18.8x Dividend Yield 1.2% 2.4% 10-yr. Treasury 6.2% 3.8% -25% 1,200 1,000-49% +101% Sep. 30, 2008 P/E (tr) = 18.8 P/E (fw) = , Dec. 31, 1996 Oct. 9, 2002 P/E (tr) = 19.2 P/E (tr) = '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 Source: Standard & Poor s, First Call, Compustat, FactSet, JPMorgan Asset Management. S&P 500; still searching for a bottom? 46% decline by mid-october. Writedowns by financials continue to pummel the S&P 500. Volatility is at historically wide levels. Chicago Board Options Exchange Volatility Index surged to an intra-day record. 6

8 The Lead-In: Markets Pulse Length of Economic Expansions and Recessions Since Average Length (months): Expansions: 45 months 100 Recessions: 14 months Recessions and Market Returns Return Length During 6-mo's Year (months) Recession After % 12.2% % 16.4% % 20.4% % 9.0% % 20.6% % 1.1% % 8.2% % 18.8% % 4.0% % -4.5% AVG % 10.6% Source: NBER, Standard & Poor s, JPMorgan Asset Management. History doesn t repeat itself, but it does rhyme. Mark Twain 7

9 N U G G E T T A G : u s e r N a m e = n u l& p lo t N a m e = n u l The Lead-In: How did we get here? Investors and Wall Street have a short memory. Default Rates During the 2001/2002 corporate fraud era, defaults increased; spreads widened, equity markets declined. 1,000 Corporate Spreads 800 Source: LehmanLive.com This was followed by a very benign risk environment. Tight credit spreads Low default rates Strong demand for credit Which created an opportunity for the structured credit market to boom. US Credit A OAS US Credit BAA OAS US High Yield OAS 8

10 The Lead-In: Demand for investments was greater than supply Institutional investors, hedge funds, private equity firms and sovereignwealth funds had cash to invest. Investors searched for yield. Low interest rates Tight spreads Low volatility Virtually no defaults 9

11 Collateralized Debt Obligations - CDOs Collateralized Debt Obligation (CDO) unregulated type of asset-backed security and structured credit product. Constructed from a portfolio of fixed-income assets Assets are divided into tranches by ratings Losses are applied in reverse order of seniority $Bn 600 Global CDO Market Issuance Source: Securities Industry and Financial Markets Association CDOs offered returns that were often 2% - 3% higher than similarly rated corporate bonds. Demand for synthetic CDOs surged. 10

12 CDOs turn Toxic The math ended up driving the way CDO portfolios were put together. Bankers loaded the securities with bonds and swaps offering the highest return for a given credit rating Many institutions lacked the competency to monitor credit performance and/or estimate expected cash flows Approximately $254 billion of CDOs tied to sub-prime mortgages have defaulted. Losses on CDOs tied to corporate credit may spark the next round of writedowns. 11

13 Relevance to Insurance Investments The bulk of a life insurance company s general account is typically invested in fixed income securities. Provides a steady stream of income Allows matching of asset and liability cash flows and duration Minimal RBC change versus equities or alternative assets Bonds as a % of Invested Assets Large Company Comparison Public Company Comparison Mutual Company Comparison Large Company Composite represents an asset-weighted average of 19 large life insurers. Mutual Company Composite includes: Mass Mutual, Nationwide, New York Life, Northwestern, Pacific Life, and TIAA. Source: J.P. Morgan 12

14 Relevance to Insurance Investments As investors searched for yield, the allocation to structured products increased. Composition of the Bond Portfolio as a % of Total Bonds US Gov't & Agency Debt Credit Structured Short-Term Large Company Comp. Public Company Comp. Mutual Company Comp. Large Company Comp. Public Company Comp. Mutual Company Comp. Large Company Comp. Public Company Comp. Mutual Company Comp Source: J.P. Morgan 13

15 Lessons Learned Stick to Fundamentals The Components of Insurance Investment Strategy Business Strategy Liability Characteristics Investment Operations Strategic Asset Allocation Tactical Asset Allocation Investment strategy is designed to help operating businesses keep the promises they make to customers: For policyholders with current claims, funds are available for timely payment. For all other policyholders, the company s financial future is secure. For potential policyholders, pricing is competitive. From a shareholder perspective, the investment strategy is designed to support business strategy and generate an acceptable return while protecting against threats to capital formation, liquidity and valuation. 14

16 Lessons Learned Go back to basics Set investment objectives and risk budgets. Adjust your asset allocation to your risk tolerance. Include the possibility of tail risk Diversification matters Mind the correlations Manage Liquidity Maintain robust ALM process. 15

17 N U G G E T T A G : u s e r N a m e = n u l& p lo t N a m e = n u l Opportunities Confidence in the financial system is at an all-time low. Shift in concern in recent weeks from financial crisis to global recession. Spreads on investment-grade credits are at historically wide levels. Corporate Spreads 1, US Credit A OAS US Credit BAA OAS US High Yield OAS Issuer Rating Maturity Spread Yield Kimberly Clark A2/A 10-yr % 3M Company Aa1/AA 3-yr % CSX Transportation A2/A- 6-yr % PepsiCo Aa2/A+ 10-yr % IBM A1/A+ 10-yr % 16

18 Outlook - What Next? Health of financial sector Next shoes to fall? CDS credit cards industrial credits state government funding issues such as California Increasing defaults LBO debt from recent years will be hard to refinance Government response of new administration Global slowdown 17

19 Outlook There is Hope Markets eventually recover from even the sharpest downturns. Peak to Trough Months to Recapture Loss from Trough Recession Decline 25% 50% 75% 100% % % crash -34% % % % (so far) TO BE DETERMINED Source: Wachovia Securities Market Returns After Consecutive Down Years (S&P 500 Index) 160% 120% 80% 40% 0% -71% Source: JPMorgan 148% Great Depression -34% 100% World War II 57% -42% -40% Oil Crisis 67% Internet Bubble War on Terrorism 18

December 2014 FINANCIAL MARKET REVIEW

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